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Will more follow Northrop’s lead and buy vs. lease?

Proposed accounting change drove contractor's departure from the norm

By David Hubler

Aug 24, 2010

Northrop Grumman Corp. will soon relocate its long-time Los Angeles headquarters to a 14-story building in Falls Church, Va., which the company recently purchased from ING Office Fund for a reported $78.6 million in cash.

Other federal contractors could follow Northrop’s lead, opting to buy rather than take the more conventional leasing route, if a proposed accounting rule change takes effect around 2013.

The accounting change – a joint proposal of the Federal Accounting Standards Board which issues regulations under the Generally Agreed Accounting Principles (GAAP) and the International Accounting Standards Board – would change the way leases can be accounted for on corporate financial statements.

Under current accounting practices, most companies record their leasing costs as an expense but not as a liability, according to the Real Estate Roundtable, an industry advocacy group in Washington, D.C.

“Under the proposed new standards, due to be officially released for public comment in late August or early September, companies will be required to record operating leases as a ‘right of use’ (ROU) asset and as a corresponding liability (for expected lease payments) on their balance sheets,” the Aug. 6 issue of the Roundtable’s newsletter said.

If the proposal goes into effect, so-called capital leases will be the only acceptable accounting format under GAAP, said Adam Lazarus, a director at Citrin Cooperman and Co. LLP, a tax, accounting and business consulting firm in New York City.

“The thrust of this project is to capitalize all leases on the balance sheet with the theory that your obligation to pay rent is very similar to paying debt service,” said Mindy Berman, managing director in capital markets at the real estate firm Jones Lang LaSalle.

She likened leasing to a bank loan, “but instead you’re borrowing it from a landlord.”

“You’re using their capital to secure a resource for you, which is space, to conduct your business. And that should be recognized as an obligation on the balance sheet,” she said.

Changing the GAAP regulation would also create more corporate transparency and increase disclosure, Lazarus said.

“If they’re leasing that space, they would have to put a huge liability on their books under these new accounting rules for the future payments that they’re going to have to make under that lease,” he added.

Lazarus said he assumes Northrop chose not to lease because “if they’re buying it outright, then they don’t have to put any liabilities on their books because they’re just paying cash.”

“Buying made sense, anyway; it just made more sense in light of the [proposed] rules,” Gaston Kent, Northrop’s vice president of finance, told the Wall Street Journal at the time the new headquarters purchase was announced.

In an e-mail reply to a Washington Technology request for additional information, Northrop’s corporate director of communications in Washington, Gustav Gulmert, said, “We don’t have anything further to add to the lease/buy discussion, so we are going to decline any additional comment on the topic.”

Companies whose real estate is integral to the performance of their business, such as retailers, have a lot of leased space, Berman said.

The proposed accounting change would capitalize rent to be represented on the balance sheet alongside other debt obligations. “It won’t be debt -- you’ll be able to distinguish it from debt – but it’ll be presented as another form of a financial obligation,” she said.

That means for some companies that own their properties, “the apparent debt is going to go through the roof,” she said. “For other companies that are not real estate intensive or equipment intensive, there will be less of an impact.”

In a recent Wall Street Journal article, the Real Estate Roundtable said “the forthcoming new rules will increase pressure on companies to sign shorter leases — while reducing building owners’ ability to obtain long-term leases that typically play a key role in their financing strategies.”

Berman said the proposed change also “could have a significant, adverse impact” on contractors with five- or 10-year government contracts that include reimbursement for rent. It’s an issue that will take several years to resolve, she predicted.

Nevertheless, she said, Northrop's decision to purchase its new headquarters property may make sense because it is establishing a long-term address.

“But, in general, companies don’t occupy full buildings and they want the flexibility of being able to move around and they like having [use of] someone else’s capital,” she said.

“Theoretically, a company like Northrop makes more from conducting its business than in investing in real estate,” Berman said.

But even without the expected rule change, corporate leasing in the Washington/Baltimore corridor is on the decline.

According to a report by Trendlines, gross leasing activity in the region totaled 17.1 million square feet in 2009, below the 10-year average of 20.9 million square feet.

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